There’s a lot of conflicting information on the web when it comes to stop losses.
Recently I saw a YouTube video explaining that professional traders don’t use stop losses because doing so alerts market makers and algorithms to where their orders are.
This is mostly nonsense especially in liquid markets with thick order books.
The fact is most traders need to use stop losses to protect themselves from huge risk.
But it’s also true that many professional traders don’t use stop losses.
And it’s not for the reasons you’d expect.
#1. Because they’re reckless
Professional traders are often put on a pedestal but the truth is a lot of them are reckless when it comes to risk management.
When I worked on a prop desk I learned that many traders avoided stops.
I have come across traders who are so confident in their opinions that they do not think a stop loss is necessary.
I’ve even witnessed pro traders aggressively average-in to trades in order to get out of their losing positions at a tiny profit or break-even.
Many traders I have met are stubborn and reluctant to take even a small loss on a trade if they think their opinion is correct.
There is no doubt that this is reckless behavior and it exists among pro traders and retail traders alike. But traders who work like this usually don’t stay in business for long.
#2. Because they have a hedge
A common reason why a professional trader won’t use a stop loss is because he is hedged with some other trade.
This is particularly prevalent with certain types of trading such as spread trading, stat arbitrage or high frequency trading.
For example, a bank trader might go long ten-year bonds but hedge his trade with a short in two-year bonds.
A fund might go long AAPL but keep a hedge in place with SPX puts.
There are numerous ways to build a hedge which eliminates the need for a fixed stop loss.
#3. Because they use mental stops
One of the main reasons professional traders don’t use hard stop losses is because they use mental stops instead.
The advantage of this is that you don’t have to ‘give away’ where your stop loss is by placing it in the market.
This strategy is only possible if you are focused on the market the whole time you have a trade on.
The moment you look away from the chart, there’s a chance that the market will drop below the level you wanted to get out and you will have messed up your risk management.
The influence of algorithms also means that sharp moves and flash crashes can occur faster than a human trader can react. That’s what makes this a dangerous strategy.
#4. Because they’re not using leverage
Some professional traders actually don’t use much leverage which means they can size their positions small enough so that a fixed stop loss is not usually necessary.
For example, consider a stock trader who puts 5% of his $100,000 portfolio into Apple.
Assuming two-to-one leverage, Apple would have to go to zero for this trader to lose only $10,000. Clearly that is not going to happen any time soon.
If you size your position small enough you can get away without a stop loss and instead exit trades according to your rules.
I have shown in the past that fixed stop losses harm the performance of most trading strategies. Therefore it’s better to size your positions small and exit your trades using your own system logic or by trailing stop.
For example, the following equity curve is for a simple RSI system on SPY with no stops:
Now observe the same system but this one includes a 3% fixed stop loss to cut short losing trades:
In this example, the net profit has almost halved by using a fixed stop loss.
Trading a conservative size is the approach we usually take with the strategies on our program, although experienced traders can add leverage if they wish.
#5. Because they trade options
Of course, lots of professional traders don’t use stops because they trade options.
Buying options give you the ability to define your risk from the start so that you know the maximum amount you will lose on a trade if you’re wrong.
However, this isn’t always true if you sell options.
‘Naked’ selling of call or put options can expose you to theoretically unlimited risk and get you in a lot of trouble quickly.
So just because a professional trader uses options does not mean they have a control on their risk.
The idea that professional traders don’t use stop losses is a dangerous myth that should be ignored.
There will always be reckless traders but the fact is if you trade with leverage you expose yourself to a huge amount of risk.
The use of leverage means you could lose more money than is in your trading account so you always need to have a hard stop loss in place to protect yourself from a devastating loss.
Getting stopped out is painful and it is always better to exit your trades according to your strategy rules if you can.
The key is to size your positions small enough so that your hard stop loss is hit only on rare occasions.
Thank You For Reading
Joe Marwood is an independent trader and the founder of Decoding Markets. He worked as a professional futures trader and has a passion for investing and building mechanical trading strategies. If you are interested in more quantitative trading strategies, investing ideas and tutorials make sure to check out our program Marwood Research.
This post expresses the opinions of the writer and is for information or entertainment purposes only. It is not a recommendation or personalised investment advice. Joe Marwood is not a registered financial advisor or certified analyst. The reader agrees to assume all risk resulting from the application of any of the information provided. Past performance, historical or simulated results are not a reliable indicator of future returns and may not account for real world settings. Financial trading is full of risk and margin trading can lead to financial losses totalling more than what is in your investment account. We take care to present accurate analysis but mistakes in backtesting and presenting of analysis regularly occur. Please read the Full disclaimer.
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